October 2018 Client Letter

Client Letter, October 8, 2018

 

Quick Summary: The end of an era may be at hand. The rally in bond prices that dates back to 1981 appears to be over. I’m not convinced it’s over for good but that’s an argument to be made later on.

In the meantime, falling bond prices represent a headwind for stocks and could remain so until bond prices find a short term floor. This headwind accelerated the decline in stocks on October 4th and 5th. This prompted me to raise cash from holdings that either had losses or were laggard holdings. A portion of cash was used to purchase hedges to offset any future stock price declines.

It’s most likely that this is just a short or intermediate termed decline in stocks as the long term trend remains firmly in place. Part of the purpose of quick market declines is to make investors fearful and uneasy, one reason we use hedges to cushion declines.

 

Chart 1: This chart below shows that the long term trend to lower interest rates is being threatened. This can’t be a surprise with the rapidly expanding deficits and very low unemployment. But as I’ve highlighted with arrows: it’s not uncommon for interest rates to rise in the latter stages of the business cycle, only to fall hard when the Fed raises rates enough to trigger recession. I don’t see this time as any different. My best guess is the current bond weakness is a future buying opportunity later in 2019.

Socially Responsible Investing, RMHI

 

Chart 2: Proxy for the 30-Year T-bond is the TLT. The chart below is inverse to Chart 1 above. Any further weakness with a close below $113 could accelerate the bond sell-off which would trigger more stock market weakness in the short term.

 

Chart 3: A direct beneficiary of the decline in bond prices is setting itself up for a very good risk/reward trade. As the bond market declines, the TBT will rally higher.

 

Chart 4: Internal market strength was showing an important discrepancy with the Advance/Decline line which did not confirm the most recent market peak as it should. This non-confirmation gives us a clue that internally at present the stock market is not very healthy and is in need of a purge.

 

My guess is that the selling is not finished. We may bounce here for a day or two, but if the bond market continues to be weak, the Nasdaq Composite (Chart 5) could visit 7500 or so quickly. Selling would likely be contained at that level. Odds are high this is not the start of a bear market for stocks.

 

Chart 6: Our long term primary trend indicator remains quite positive at present. Market tops are usually made by a rolling-over process rather than a mountain top peak. See my estimates for business cycle – stock market peak below.

Parlor game guesses for cycle peaks

Based on the Fed’s rate hike projections, we’ll reach inversion by February 2019. The Fed has given no signal to indicate they’ll declare a halt to rate hikes which could push the date to later next year. In fact the most recent jobs data makes me think they’ll hit the brakes hard next year.

So, based on an inversion in February 2019 we can make some recession date assumptions based on the past 9 yield curve inversions dating back to 1957:

The shortest lead time from inversion to recession has been 8 months: October 2019. Median lead time from inversion to recession has been 12 months: February 2020.

Longest lead time from inversion to recession has been 20 months: October 2020.

Understand the recession data is based on NBER declared recessions and they date the start of a recession many months in hindsight. But we can make reasonable estimates based on yield curve inversion dates.

The stock market is a forward looking barometer meaning that the markets look ahead into the future. This means the US stock market will peak and begin to rollover before the recession starts.

Based upon data from 1957, the US stock market has peaked on average 5 months before the start of a recession.

Earliest estimated stock market peak is May 2019. Likeliest estimated stock market peak is September 2019. Latest estimated stock market peak is May 2020.

Thanks again to all of you for your trust. As an investment manager, my goal is to avoid the dogmatic approach, be flexible and neutral to market behavior. Any investor who decides to get into an argument and mansplain to the market will emerged bruised and poorer for the experience.

All the best,
Brad Pappas

Disclaimer; Socially Responsible Investing

 

 

 

 

 

July 2018 Client Letter

“Nothing but blue skies ahead”

National Trade Council Director Peter Navarro
– June 25th, 2018

July 1, 2018

Summary: Last month I wrote about the Fed and what I expected could happen by the end of 2018 or early next year. My timing last month was too optimistic as things are coming to a head now. I expect the 3rd quarter to be volatile with a downward bias as the Fed and the European Central Banks (ECB) continue to destroy their economies and markets with policy errors.

The world’s stock markets are in the process of crashing. It’s naive to think that the ripple effect will not happen here. Unless the Fed states that they’re going to pause raising interest rates or halting QT (see below), we can expect a market sell-off in the 15% range. This may be one of the reasons Trump tweeted that he asked the Saudis to increase oil production. There isn’t much inflation in the system right now except for energy prices. By increasing production with the hope of lowering the price of oil, it may be enough reason to for the Fed to halt rate hikes. But we really don’t know what the Fed will do at this point.

At the start of last week, we had three big issues to contend with.

1) The rapid rise of the U.S. Dollar (USD) versus the Chinese Yuan.

China does manipulate their currency against the U.S. as detailed in the chart below. Spikes in the USD/Yuan valuation in recent years have been catalysts for dramatic sell-offs in U.S. stocks. Part of the problem is, in a world starved for short term yield, money is now being converting to USD to buy short term yields. In addition, the effect of QT (See below #3) is also a cause for the increase in demand for USD to buy Treasuries. Regardless of the reason, the devaluation of Chinese Yuan negates much of the tariff risk to China while also having a negative effect on the U.S. economy as U.S. goods become more expensive. Add tariffs to the mix and you can expect a significant slowdown in U.S. growth soon.

UUP-CYB, Socially Responsible Investing

The rise of the USD – caused by the Fed raising short term interest rates and investors liquidating short and intermediate term bonds – is causing Emerging Markets (EEM) to crash. The break below the EEM’s primary moving averages occurred at the same time the Fed most recently raised interest rates.

EEM, Socially Responsible Investing

I had been watching the EEM exchange traded fund (ETF) along with its inverse ETF which rises as the EEM declines. We were able to make initial purchases in the $41-$43 zone. See below. I am using the EEV as a hedge against our current stock holdings.

EEV, Socially Responsible Investing

This is how the world’s regional markets are reacting to Fed and ECB policies:

EIDO, Socially Responsible Investing

 

ILF, Socially Responsible Investing

 

FXI, Socially Responsible Investing

 

EEMA, Socially Responsible Investing

 

VGK, Socially Responsible Investing

All of these international charts are in the Bear Market zone.

2) The Yield Curve

The Yield Curve continues to decline and, unless the Fed stops raising short term interest rates, it should cross below the 0 threshold which will signal an incoming recession. For more on this click on the following link.

https://www.federalreserve.gov/econres/notes/feds-notes/predicting-recession-probabilities-using-the-slope-of-the-yield-curve-20180301.htm

UST, Socially Responsible Investing

In the chart above, the closer the Yield Curve gets to zero, the more nervous investors will become.

The studies show the recession could be as long as a year or two following an inverted yield curve. But stocks move in anticipation of the future, and the Financial and Industrial stocks in the U.S. are moving into Bear Markets. We don’t need another banking crisis but that exactly what the banks are showing. Just brilliant timing by Congress to eliminate many of the restrictions after the 2008 debacle.

The industrials have to contend with both trade wars and the Fed raising rates. They’re signaling that our present GDP growth is coming to a hard stop unless the Fed stops their behavior.

XLI, Socially Responsible Investing

High Yield Bonds – otherwise known as Junk bonds – can act like an early warning signal as they are a reflection of the risk in credit markets. If Junk bonds are selling off and Treasury bonds are rallying, that tells us there is trouble brewing as money exits risky credit for safe credit.

HYG, Socially Responsible Investing

High Yield is on the verge of signaling that credit markets could be become increasingly concerned about risk.

3) Quantitative Tightening (QT)

Lastly we have QT. QT is the inverse of QE known as Quantitative Easing. After the collapse in 2008, the Fed and the ECB went on a series of actions (QE) whereby the Fed bought huge amounts of Treasury bonds in an effort to lower interest rates making stocks, treasuries, real estate etc… more attractive. In doing so, they created huge wealth for those who owned risk- oriented assets. However, the downside is that the Fed now owns a huge inventory of bonds and other securities and they have mandated that they must now begin selling off their inventory to “reduce their balance sheet”.

The liquidation on the open market by the Fed and the ECB is known as QT or Quantitative Tightening. When a central bank sells a security on the open market, the buyer is giving cash to the Fed in exchange for the security. On a mass scale, this reduces the amount of cash or USD in the system.

The primary driving force in the stock market is the ebb and flow of cash in our economy, otherwise known as liquidity. When cash is coming into the system, it makes its way into the markets and drives prices higher. The inverse is also true but we’ve never actually experienced QT before. It could be a disaster on its own. But combined with rising short term interest rates, it could be lethal to the buy-and-hold long term investor.

I’ve shown many charts that show the deterioration of the markets in the U.S. and abroad. In June, the Fed was selling off $30 billion in inventory a month and look at how much damage that created.

Come this month (July), the Fed and the ECB will both be enacting QT. The Fed is scheduled to raise the amount of liquidation from $30 billion a month to $50 billion.

Summarizing

I believe the Fed’s attempt to normalize interest rates is failing. My guess is that, at some point, the Fed will stop but the question is how much further damage will be done before they signal a white flag.

In the past two weeks, I’ve reduced our clients’ risk exposure greatly by adding inverse exchanged traded funds and adding Treasury bonds. Treasury bond prices should rally quite nicely if the Fed continues on its course of action as money moves to safety.

Should there be further weakness in the S&P 500, I’d like to add inverse ETF’s based on the SP 500 as well. A break below 2670 would potentially signal a much further decline ahead.

If you’re a new investor or have capital you’d like to add, this could be an opportunity for you, especially if we have a steep decline and the Fed backs off from rate hikes.

What else could happen? The Chairman of the Fed is Jerome Powell and he will be under intense pressure to stop their present course. Pressure is not surprisingly coming from the White House as well as the Fed is a threat to kill the Presidents economic agenda.

If Powell signals that the Fed is done with raising rates then a move to 3000 in the S&P 500 and a sharp sell off in long term treasury bonds is not impossible. Stay tuned. But my guess is there will be considerable damage done first.

Powell was appointed by Trump and it’s my understanding he can be fired as well. A firing would be considered a major positive event for risk markets.

Time will tell and this period will pass as well. It’s a time to be very cautious and hedged against risk.

We are positioned to protect our client accounts and benefit if a major decline occurs.

The irony of all of this is I didn’t even mention Trade Wars. But they’re easy to win so it’s all good.

Brad Pappas

Disclaimer; Socially Responsible Investing